July 2016 User View by Claudia Volk, Associate Director, Research Products, Sustainalytics, Germany
THE crux of materiality is “the threshold at which sustainability topics become sufficiently important that they should be reported”, says the Global Reporting Initiative (GRI) Guidelines. This points to what the GRI and RobecoSAM (see Defining What Matters 2016) recently called “sustainability reporting materiality” versus “financial materiality”. GRI urges companies to undertake a stakeholder process to define thresholds and use them to determine which issues are considered “material” for sustainability reporting purposes.
Looking then at financial materiality and investor interests, at first glance, the shareholder perspective appears as just one of the broad range of stakeholder perspectives the GRI has in mind. However, one can also argue that investors are interested in those issues viewed as material by other stakeholders, ones that reverberate on the company. Investors are therefore interested in assessing the combination of behaviour and reactions, internally and externally. They want to know how companies assess material issues and how they intend to react to them – for example which response strategies they have.
The discrepancy between how materiality is defined for sustainability reporting purposes versus for investment decision-making purposes contains an exciting dynamic by highlighting factors that are regarded material by some stakeholders, but not yet by (risk-driven, long-term) investors as they do not yet affect a company’s enterprise value significantly. Here the theory of a tipping point comes into play: these stakeholders might spearhead a movement that influences the thinking by consumers and politicians on a topic, which could eventually make the topic material to investors.
Investors should, therefore, be especially interested in determining which ESG issues that matter to any of the various stakeholder groups will become important enough to affect shareholders, and when this is likely to occur. When do customers’ preferences shift to the extent that revenues are significantly affected? When do citizens’ concerns drive the implementation of new regulations that create new costs for companies? At which stage do stakeholders withdraw a company’s license to operate? When these tipping points are reached, externalities become internalized.
Do investors ultimately need financial thresholds to identify these tipping points?
Materiality is a fundamental principle in accounting, finance and reporting. An issue is considered to be (financially) material, if its presence or absence is likely to have a (significant) effect on the market value of an enterprise and hence on the decisions made by a reasonable investor. This concept implies the existence of thresholds that tell us where this “significant” or “important enough” starts. As a company’s ability to generate profits depends on a mix of factors from various areas with varying importance, the idea to weigh the various trends by financial significance seems quite reasonable. Yet it can be extremely difficult to define these thresholds in numbers.
First, one has to define what represents a “significant” impact on a company’s enterprise value. Is it when a company’s existence is at risk, which probably determines materiality for bond holders? Or is it a significant share price drop, and therefore an expected reduced ability to generate profits in the future? How much and for how long is a “significant” share price drop?
Second, it is very difficult to assess the impact of sustainable (or “pre-financial”) issues on (potential) shareholder returns. (The term “pre-financial” conveys the fact that the impact of the issues on shareholder returns is not direct, but still may occur.)
One can say that an issue becomes material as soon as the costs (including missed revenues) for ignoring an issue exceed the costs for dealing with the issue (significantly). The point where this occurs – where the cost structure significantly changes since regulations changed, non-compliance implies fines, or consumers changed their demand patterns – can be called a tipping point.
In many cases, diverse areas of impact are highly correlated as small groups of citizens (e.g. scientists or trend setters) may initially raise an issue, and over time – often with the support of media – momentum builds, more and more people get engaged, consumer patterns change or regulations are adjusted. This leads to tipping points. “The tipping point is that magic moment when an idea, trend, or social behavior crosses a threshold, tips, and spreads like wildfire” says Malcolm Gladwell in his book The tipping point (LB 2002). In climate science, a tipping point characterizes the threshold for abrupt and irreversible change. In epidemiology, the tipping point is the point where a critical mass is reached.
Examples in the economic world can be seen in many areas, and include increasing demand for organic and healthy food, REACH regulations, climate change treaties, cluster munitions bans, stricter prosecution of business ethics cases in the banking sector following financial crisis, or Germany’s decision to withdraw from nuclear energy after the Fukushima disaster.
Identifying or forecasting tipping points is about analyzing trends and patterns of change, as well as identifying the influencing factors and understanding their potential impacts. It includes analyzing socio-economic developments, with their impact on consumer patterns, as well as understanding cost drivers related to sustainability factors. The materiality tests that for example GRI and SASB propose are useful to approach the relevance of an issue, as they take several aspects into consideration that help to assess if an issue is or may become financially material. It is, however, also essential to gain insights into cost structures and revenue drivers, as well as the influencing factors and trends.
Tipping points refer to large-scale, systemic developments. Long-term investors and in particular “universal owners” invested in all the different asset classes and industries are much more prone to the impacts of long-term developments than smaller investors are. Large investors face more difficulties to respond quickly to developments by switching their investments. Similarly, hedge funds and equity investors can react faster to certain developments, whereas investors that invest in real assets (e.g. infrastructure) may face liquidity risks that limit their flexibility. For the latter, foreseeing long-term challenges and identifying tipping points with regard to sustainability issues is highly relevant. Investors that take into consideration not only financial figures but also “pre-financial” ones – factors that indirectly (may) impact a company’s ability to generate returns – and identify tipping points for these, will have a strategic advantage in the long run.
The author can be reached at: claudia.volk@sustainalytics.com
